Scandinavian Working Papers in Economics

SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

No 319: Fiscal Policy with Heterogeneous Agents and Incomplete Markets

Jonathan Heathcote
Additional contact information
Jonathan Heathcote: Dept. of Economics, Stockholm School of Economics, Postal: P.O. Box 6501, SE-113 83 Stockholm, Sweden

Abstract: I undertake a quantitative investigation into the short run effects of changes in the timing of taxes for a model economy in which heterogeneous households trade only one asset and face a borrowing constraint. This asset market structure implies that the consumption of low wealth households is sensitive to tax changes. The main finding of the paper is that when the wealth distribution in the model resembles that in the United States, market incompleteness accounts for large immediate aggregate consumption increases following tax cuts, and large consumption falls following tax increases. When taxes are lump-sum, for example, a dollar change in tax revenue is associated with a 15 cent change in aggregate consumption, compared to a response of roughly one third this size when markets are complete but households are finitely-lived. I find the response to tax changes to be larger if the interest rate is constant rather than determined endogenously, and smaller if taxes are proportional rather than lump-sum.

Keywords: Fiscal policy; heterogeneous agents; incomplete markets; Ricardian equivalence; borrowing constraints.

JEL-codes: E21; E25; E62

42 pages, First version: May 19, 1999. Revised: July 28, 1999.

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